ANALYSIS-JGBs look beyond elections, brace for more supply

Published: 28 Aug 2009 01:35:27 PST

* Tax shortfall of 5-10 trillion yen seen possible

* Regardless of election outcome, more bond supply expected

* Some see extra issuance of 5-10 trillion yen this fiscal yr * Extra supply could buoy yields but forecasts vary

TOKYO, Aug 28 - Japan's government bond market is bracing for more supply no matter who wins Sunday's election, as the weak economy is expected to lead to a tax revenue shortfall of at least 5 trillion yen ($53 billion) this fiscal year.

The economy returned to growth in the April-June quarter after four quarters of contraction, but the worst recession since World War Two has cut into corporate profits and sapped the flow of money to government coffers.

Economists say it is too early in the fiscal year to forecast precisely how much extra debt will be needed, but estimate it could be 5 to 10 trillion yen whichever party wins.

"It does not matter who wins the election. A tax revenue shortfall is most likely, and the government will likely be compiling a supplementary budget towards the end of the year funded by extra debt issuance," said Yusuke Ichikawa, an economist at Mizuho Research Institute.

The market broadly expects extra supply to push up bond yields, with some seeing the benchmark 10-year yield as high as 1.8 percent by end-December.

But forecasts vary, and some market watchers say it could drop as low as 1.1 percent due to deflationary pressures and a stubbornly weak economy. The yield <JP10YTN=JBTC> closed at 1.310 percent on Friday.

The government has already increased new JGB issuance once this year to a record 44.1 trillion yen, up from an initially planned 33.1 trillion yen.

It had expected to collect 46.1 trillion yen in taxes in the fiscal year that began in April, but economists estimate the shortfall could reach as high as 10 trillion yen.

Cumulative tax revenues stood at 2.02 trillion yen as of the end of June, the third month of the fiscal year, down 17.2 percent from the same period last year.

Newspaper surveys show the opposition Democratic Party of Japan (DPJ) is set to win the election, possibly by a landslide. [ID:nT231044]

It wants to slash 9.1 trillion yen of spending it deems wasteful and tap special reserves to fund steps it plans to begin rolling out next fiscal year, such as increasing disposable household income and scrapping public high school fees, without increasing taxes or relying on extra debt.

DPJ leader Yukio Hatoyama vowed last week not to increase debt issuance next fiscal year if his party takes power.

But many economists expect a supplementary budget before the end of December to address the likely drop in the tax take. Whichever party wins, some economists do not rule out that they may be tempted to add funds for fresh stimulus. [ID:nT140785]

"It will depend on how the DPJ can utilise funds from the special reserves...," said Masamichi Adachi, a senior economist at JP Morgan.

"Consumer spending has flagged this summer. The DPJ will probably try to utilise as much funds as possible inherited from the LDP's fiscal stimulus package, but it may compile additional packages during the remainder of the fiscal year to help households."

SUPPLY ALREADY RAISED ONCE

The ruling Liberal Democratic Party (LDP) compiled a 15.4 trillion yen economic stimulus package in April on top of the annual budget, and national debt has ballooned to about 170 percent of gross domestic product, the highest among industrialised nations.

The LDP plans to raise the 5 percent consumption tax once the economy recovers to fund social welfare costs. [ID:nT287409]

But the JGB market is unlikely to heave a sigh of relief if the ruling party keeps power, as economists expect that it too would have to issue more due to the tax shortfall.

Hidenori Suezawa, chief fixed-income strategist at Daiwa Securities SMBC, estimates additional JGB issuance in the remainder of the fiscal year could come close to 10 trillion yen to meet the shortfall and fund any further spending plans.

The 10-year government bond yield rose to an eight-month high of 1.560 percent in June just before the extra bond supply hit the market.

But it largely has taken in its stride the 11 trillion yen issued since then, which has been spread across the yield curve.

This is in part because of deepening deflation and doubts about how sustainable the economic recovery will be once stimulus measures wear off. [ID:nT238602]

Analysts say the Bank of Japan's easy monetary policy, uncertain economic prospects and deflationary pressures could help the market absorb more supply on top of the current issuance programme without pushing yields up too far.

Expectations for the yield range from 1.1 percent, on the back of deflationary pressures and a weak economy, to as high as 1.8 percent by the year end.

But they say the curve could steepen as longer-dated maturities will benefit less from steps by the central bank to maintain easy monetary policy, such as outright bond buying.

The two-year/20-year yield spread steepened to 190.5 basis points early in August, its widest in four years, from 160 basis points three months earlier.

The spread was at 182 basis points on Friday. * For more on Japan's Aug. 30 election, click [ID:nPOLJP]] * For more on the Japanese economy click [ID:nECONJP])